Commentary: New property tax another sign of currency-peg stress

By targeting non-resident buyers with a new tax, finally the government is acknowledging the role of offshore demand in its overheated property market. The key measure is the introduction of a transaction tax of 15% on non-permanent residents, as well as all corporates purchasing residential property.

Such taxes go against Hong Kong’s free-market ethos and are likely to hurt some unintended targets — expatriates for one. But it looks well designed in the sense it should change behavior and immediately choke off some external investment demand for residential property.

Two rounds of earlier measurers largely focused on taxing an early resale and rationing mortgage availability. This was never likely to make much difference to one of the biggest sources of buying: wealthy mainland Chinese seeking to diversify their holdings into Hong Kong’s tax haven.

The tax brings a number of potential risks, however. The obvious one is that it could topple the property market.

Having left it so late to take aim at the influence of overseas buyers, there is now a much larger property bubble to deal with. The government has been warning about escalating property prices as far back as 2009, yet ignored repeated calls to limit overseas purchases.

And while new Hong Kong Chief Executive CY Leung took office in July talking tough on dealing with unaffordable property, instead the market went on a further rally.

Property prices have risen 20% so far this year and are already past the 1997 bubble high. When that burst, prices fell as much as 70%, leading Hong Kong into a half decade of deflation.

Today, the price of Hong Kong real estate appears to have decoupled from any rational link to local affordability. Barclays Capital argued this is because of a reduction in leverage in the market and a decline in owner occupants in recent years.

Rather than providing homes, Hong Kong property has been acting as a “deposit box” for people to hold investments in a market that is predominately equity-driven, rather than mortgage-driven.

This distinction matters. An equity-based property market tends to be more volatile, as it is driven by changes in investment demand and expectations of future price levels, rather than peoples’ decisions on where they will live.

If this is a fair characterization of Hong Kong property, it is the drivers of investment demand that matter most. Have the fundamentals really changed?

Investors will likely be reconsidering political risk and the potential for further government intervention. Financial Secretary John Tsang said on Friday the government was ready to introduce further measures, which would likely include further taxes.

But for mainland Chinese investors, there are an assortment of reasons supporting property investment in Hong Kong from offshoring money to a more attractive tax regime.

The other gorilla in the room is the currency play. The peg of the Hong Kong dollar to the U.S. dollar has been an important dynamic in mainland Chinese investing.

For one, it means Hong Kong property has appeared less expensive after the yuan has gained over 30% against the dollar in recent years.

And keeping some money or assets in Hong Kong also gives all investors an option on a potential currency appreciation.

A longstanding belief is the Hong Kong currency should eventually be pegged to the yuan or a basket of currencies. The timing, however, is not expected before China is ready to make the yuan fully convertible. But this may not be just up to Beijing.

Another risk with the latest move is that it again flags to international investors the stresses facing the 29-year-old currency peg as its strains under “hot money” flows. Arguably, it is at the root of local asset inflation by forcing the importation of low interest rates and a weak currency value from the U.S.

Over the past 10 days, the Hong Kong Monetary Authority has repeatedly had to intervene to stop the currency from strengthening by selling Hong Kong dollars.

Some investors will interpret the new tax as sign such pressures are escalating.

There have already been questions about how effective the tax will be in curbing wider capital flows. Some property experts predict the tax will simply divert investment into commercial and industrial property. There have already been some signs of this, as investors try to skirt stamp-duty resale restrictions in the residential market.

Higher prices here will also be a problem. It would mean increased costs for businesses at a time when exports, retail sales and stock-market turnover have all been declining.

All said, Hong Kong will struggle to find a painless way out of its asset bubble.

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